Lower U.S. Inflation

August 18, 2009

Producer prices fell 6.8% in the year to July, a 16.7 percentage point turnaround from its 9.9% rise during the year to July 2008. Core PPI inflation slowed to 2.6% from 3.5% a year earlier. U.S. consumer prices declined 2.1% in the latest statement year, a 7.7 percentage point drop from the rise of 5.6% in the year to July 2008. Core CPI inflation of 1.5% is a percentage point lower than in the year to July 2008 and just four-tenths of a percentage point higher than the 2003/04 trough. Headline CPI inflation never got lower than 1.7% back then, when Fed officials were fearful about the possibility that the United States could slip into a Japanese-like deflation. The FOMC ill-advisedly left the fed funds rate at 1.0% from June 2003 until June 2004. Japan’s experience suggests that current worries about a replay of the 1970’s inflation are way, way overblown. By the same token, the U.S. experience earlier this decade suggests that deflation also isn’t yet close at hand.

Minutes released today by Reserve Bank of Australia (RBA) policymakers speak of a balancing act between “the risk of overstaying a very accommodative setting in a recovering economy” and “a risk of an early tightening choking off confidence and demand prematurely.” With unexpectedly positive growth last quarter, Australia narrowly missed its first textbook recession since 1991. The same cannot be said for the United States, where real GDP dropped for a fourth consecutive quarter and by 3.9% over the full-year period. The U.S. already has a significant excess of aggregate supply, and its output gap is going to widen further if U.S. growth averages little more than 2% per annum over the coming five years. The Fed will need to err on the side of ease to a greater extent than the RBA, but officials at both central banks in particular must pay particular attention to developments in personal consumption and, as the RBA minutes warn, be extra sure that any boost can withstand the eventual fading of fiscal stimulus.

Not to put too fine a point on it, but let me stress that this is why the stock market developments have been so important. Consumers know that the U.S. employment and income situations are going to remain bleak for quite a while longer. Households remain overly indebted and with limited ability to borrow because of reduced home equity. Wealth was additionally crushed by the free-falling stock market in 4Q08 and 1Q09. Does anybody doubt that U.S. GDP would have declined much more sharply last quarter than 1.0% if stocks had not recovered impressively after early March? The real economy and stock markets are in a symbiotic relationship. News headlines on Monday blamed the stock market’s setback on concern that the U.S. recovery will be weaker than assumed. It is equally important to realize that if stocks were to suffer a significant cumulating relapse, the renewed loss of wealth would validate the concerns about growth. Much has gone wrong policy-wise under the new administration. Much of the legislative agenda is stalled or modified unsatisfactorily. Other initiatives were not well-fashioned. Voter frustration, and that means consumer frustration, can be seen in falling poll ratings for the administration. But a huge success was achieved in inspiring confidence that conditions could improve. Stocks swung from free-fall to a solid recovery, and that prevented confidence from bleeding out and laid a foundation for economic stabilization.

The rebound in equities was excessive, and continuing gains are not required for stabilization to take the next step and for a fragile economic recovery to take hold . What must happen, however, is that a renewed, cumulating stock market slide must not occur. That kind of development would produce too much strain on the nascent upturn, and the present economic concerns would indeed be self-fulfilling..

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